Question

Suppose the markets change their expectations of the future value of the dollar, such that they expect it to be stronger at that time in the future than their expectation was previously (i.e., E^e decreases).

1. How would this change in expectations affect spot exchange rates assuming interest rates stay constant?

2. What would the central bank have to do to keep the spot rate from changing in the manner you described in part (a)?

Answer 1

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Question:

Answer:

a). Answer:

as per the question the expect that the dollar to be weaker in the future but now  the markets change their expectations of the future value of the dollar, such that they expect it to be stronger at that time in the future than their expectation was previously that is decreased. Because the future expection about the future value of the dollar is opposite and the marketing is expecting that the the future value of the dollar and they expect it to be stronger at that time in the future. So, now market will buy more dollar that will increase the demand of dollars and dollars will be appreciated.

b). Answer:

The central bank control the currency sport rate by buying/selling of foreign currency or assets and increasing/decreasing interest rate. When a central bank buys the foreign currency or assets then its increase the demand of foreign currency and the foreign currency appreciate against of the domestic currency and vice-vera. Other side when a central bank increase the interest rate by decreasing the money supply in the economy, its reduce the demand of money. Reducing money supply reduced or decreased the aggregate demand in the economy because reducing supply of money increased the interest rate. Decreasing aggregate demand reduced the price level and increase the purchasing power or value of the domestic currency. when a central bank decrease the interest rate by increasing the money supply in the economy, its increase the demand of money . Reducing money supply increased the aggregate demand in the economy because increasing supply of money decreased the interest rate. increasing aggregate demand increase the price level and decrease the purchasing power or value of the domestic currency. Here the central bank will buy the foreign currency or assets or increased the interest rate to to keep the spot rate from changing in the manner i described in part and vice-versa.

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